The New ETF That Could Kill Mutual Funds

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All right, so 17th century English poet John Donne didn’t have the gargantuan U.S. mutual fund industry in mind when he penned those words. But that doesn’t mean that at least some mutual fund managers and their bosses won’t be watching uneasily tomorrow as the an exchange-traded fund (ETF) version of the Pimco Total Return Fund (PTTAX) makes its debut.

Now, the ETF won’t be a duplicate of the mutual fund, the world’s largest and one of the investment products that everyone tracks. An ETF can’t use derivatives, so star manager Bill Gross and his team will have a bit less flexibility when it comes to using those securities to manage risk or tweak a position. Given that ETFs must disclose their positions daily (rather than just their top holdings at the end of each quarter, as mutual funds must do), it’s unlikely that Gross will risk encouraging thousands of hedge fund managers and traders to front-run his fund by simply replicating its holdings in the ETF.

Nonetheless, the Pimco Total Return ETF (TRXT) is a sign of things to come. It’s a bit reminiscent of the early days of the Internet, when bricks-and-mortar retailers felt compelled to respond to the rising popularity of Internet shopping by opening their own online retail divisions. Just as they recognized that shoppers weren’t going to abandon the convenience of online shopping, so Pimco is acknowledging that investors aren’t going to walk away from the inexpensive, transparent and ultra-liquid ETFs. If you can’t beat ‘em, you find a way to join ‘em.

As ETF assets have boomed, turning it into a trillion-dollar industry, so mutual fund assets have seen a slow but steady trickle of outflows, notes Todd Rosenbluth, ETF analyst at Standard & Poor’s Capital IQ. “If you’re going to lose assets, it might as well be to another product in your family,” he says, referring to Pimco’s decision to launch the ETF. True, it may cannibalize the mutual fund to some extent, but by failing to act, a mutual fund family risks losing investors to outside providers of ETFs – of which there are plenty. “A lot of mutual fund firms are asking themselves the question of whether they should get into this ETF game to save their assets,” says Rosenbluth.

Don’t expect a dramatic overnight transformation of the mutual fund landscape, however. While investors are likely to remain enamored with low-cost ETFs, and probably will be eager to sample the Pimco offering (whose fees will be set at 55 basis points, about 35 basis points lower than a typical annual expense fee charged on the mutual fund), actively managed ETFs of this kind make up less than 0.5 percent of the total ETF universe right now. Buying an actively managed investment product is, in part, the decision to buy its track record – and the Pimco ETF, unlike the mutual fund, doesn’t have one.

Two to three years from now, this debate is likely to be very different, however. Pimco’s managers are skilled, and they’ve got an incentive to make the experiment work, or risk seeing assets leave and head to an iShares corporate bond ETF or other such passive vehicle. And to the extent that they can craft an intriguing product that delivers solid results that are similar, if not identical, to those posted by the mutual fund, well, that’s pretty much game over. Why would investors stick around in the more costly mutual fund?

Rosenbluth points out that 401(k) retirement plans, thus far, don’t let their participants invest in ETFs at all, so 401(k) investors will likely stick to mutual funds. But how long will that barrier remain in place if ETFs displace mutual funds as the investment vehicle of choice and mutual funds begin to look like the modern-day equivalent of the buggy whip of a hundred years ago?

The mutual fund companies watching Pimco’s ground-breaking move have time to plan their strategies for their own transitions to the new world of ETFs. Some may opt to mimic Pimco and roll out ETFs of their own most popular mutual funds. Others may believe that switching to an ETF format wouldn’t enable them to construct a portfolio for their particular strategy or market niche, but will still be forced to cut the fees they charge on those surviving mutual funds, and also increase transparency.

It’s unrealistic to expect that the financial world will just sit back and leave the passive investment arena to ETF providers while continuing to allow the active mutual fund managers to continue doing business as though ETFs had never been invented. We’re on the cusp of yet another revolution in the financial services industry, and those who don’t see that a transformation is inevitable will become its first casualties. Pimco, it seems, is resolved not be among their number.

As Bill Gross tweeted earlier this week, citing Pixar’s Andrew Stanton, “drama is anticipation mingled with uncertainty.” He won’t even have to go to the movies to watch some drama unfold in the coming weeks, months or years.

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Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.